Business Ethics in Economics: Why It Matters for Firms

What Is Business Ethics In Economics?

In economics, business ethics is treated not as a moral add-on but as part of a firm's incentive structure. Economists do not perceive business ethics as solely the ethical side of the decision-making process within a business entity; instead, they consider business ethics as being one of the components of the company's incentive structure. Therefore, when an organisation determines the level of ethical conduct, it considers three factors: (1) the type of incentives that a profit-maximising organisation provides; (2) the amount of supervision that decision-makers have available to them; and (3) the degree of information that clients and investors have access to prior to executing a transaction.

Profit Maximisation And The Case For Ethics

Under the classical framework, when corporations are utilising the legal environment to maximise profits (i.e., reducing costs, increasing revenues, and complying with regulations), ethical conduct is only rational for a profit-maximising firm if it contributes to profitability — through reputation, trust, or reduced regulatory risk in the future. This reframes ethics not as separate from the profit motive, but as one of the mechanisms through which it operates: it can be viewed as a business motives in its own right, rather than merely a by-product of the drive for profit.

The Principal-Agent Problem And Moral Hazard

The relationship between shareholders and managers is known as a principal-agent relationship. In this type of relationship, shareholders are viewed as the "principals," and managers act as "agents," whose job it is to act on behalf of shareholders. Shareholders can't see every decision made by their agents (managers), and therefore must rely on information they receive from them. Managers have more information regarding how their company operates than shareholders, and they have the ability to decide how much of that information goes to shareholders. This is what creates the potential for moral hazard, as agents may make risky decisions that lead to self-serving actions.

Incentives encourage market participants to focus on short-term results and easy-to-measure results; however, the real cost of poor decisions may only become evident long after the manager has received compensation for those decisions. Although stock options were intended to align the interests of the manager with those of the shareholders, they often backfire by encouraging managers to pursue only short-term stock price increases. The size of the principal-agent gap can be easily measured. According to the AFL-CIO's 2024 Executive Paywatch report, in 2023 the average CEO earned over 250 times the compensation of the average worker, taking home over $17 million.

Information Asymmetry And Market Failure

When information asymmetries are significant, dishonest behaviour may allow a corporation to make higher profits in the short term, while the negative effects on customers or investors may only become clear much later. From a rational economic perspective, buyers may respond by lowering their willingness to pay for all offers, meaning that both honest and dishonest firms can be placed at risk of being pushed out of the market.

Case Studies In Governance Failure

Wells Fargo's 2016 unauthorised-account scandal shows how this can go wrong in practice. Employees of Wells Fargo opened accounts without the consent of customers to meet quotas set by their management, while senior management at Wells Fargo, including former CEO John Stumpf, were unable to identify a problem with their compensation structure. Wells Fargo has subsequently clawed back roughly $180 million in compensation from the firm's senior executive leaders in what was one of the largest clawbacks on Wall Street ever, although it was done years too late.

Enron's collapse was due to systematic fraud in accounting through the use of off-balance-sheet entities to hide debt while inflating earnings. During this time, both the Enron board and the auditors failed to provide any meaningful oversight. The collapse of Enron resulted in the Sarbanes-Oxley Act and the rigid framework of rules-based financial reporting and internal controls imposed upon public companies in the US. In contrast, the UK has enacted a principles-based Corporate Governance Code as supervised by the Financial Reporting Council with a preference for principles-based standards rather than the imposition of rigid, rules-based financial reporting requirements, as well as a more direct relationship between executive compensation and long-term strategy.

What The Governance Instruments Actually Aim To Solve

The tools of governance attempt to ameliorate the asymmetry of information between shareholders and their managers, either by narrowing the gap through current forms of compensation or by reforming the manner in which compensation is paid out. However, Wells Fargo previously had clawback mechanisms in place before its scandal and they had no effect on preventing the scandal. The agent will invariably continue to have more knowledge than the principal, and will continue to be compensated based upon measures that can be controlled by the agent.